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Mutual Funds and Mutual Fund Investing - Fidelity Investments

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While money market funds can be considered conservative investments, they still involve a degree of risk. Because of this, it is important to know what is held in their portfolios.

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Pay special attention to a key characteristic of Certificates of Deposit (CDs) - they are FDIC insured. This is an important feature to keep in mind when evaluating the risk levels of your fixed income investments.

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Pay special attention to the “Who issues bonds” section of this article. Each bond type has certain advantages and disadvantages that will be integral when making your investment decisions.

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In the previous lessons, the basic fixed income investment types were reviewed. Now let's move on to pricing, rates, and yields and the interaction between them. When investing in fixed income it is imperative to understand how they affect each other.

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Bond funds can offer an easier way to achieve diversification, even with a small investment. The impact on a portfolio from one bond defaulting or being called away prior to maturity may potentially be lessened by owning a large number of bonds.

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There are many pros and cons to investing in bonds and bond funds, such as tax implications. Make sure you understand the differences and potential impacts of each.

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Building a portfolio of fixed income funds starts with identifying your investment goals, then understanding how different types of bond funds align with those goals

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In this lesson pay special attention to how bond ratings can affect price and yield. This will be an important aspect of evaluating a bond fund, which is reviewed in the next lesson.

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This lesson includes three important questions you should ask yourself when evaluating a bond fund. Save these questions, as they may be asked when considering any type of investment

Bonds vs. bond funds

Once you’ve decided that you want to allocate a portion of your portfolio to bonds, you’ll need to decide how exactly you want to buy and own those bonds. You have two primary options: Buy individual bonds or purchase a mutual fund that invests in bonds.

There’s no definitive right or wrong answer here; each option has its pros and cons. In some cases, it makes the most sense to combine individual bonds with bond mutual funds. A right choice for you depends on your ability and interest in researching your initial investments, your willingness to track them on an ongoing basis, the amount of money you have to invest, and your tolerance for different types of risk.

Individual bonds

A distinguishing feature of individual bonds is their commitment to pay out a defined amount of income at regular intervals, usually twice a year. This income is generally expressed through the coupon—which in most cases is fixed. The bond’s principal is returned to you when the bonds mature.

Another key differentiator of individual bonds is that they give you the ability to buy into a fixed rate of return, or “yield” at the time of purchase. By calculating the future cash flows—based on the bond’s coupon and principal— as a function of the purchase price, it is possible to derive a total return or yield to maturity—or yield to call in the case of callable bonds. This yield is the annual return on your initial investment through some predetermined future date. Remember, achieving this calculated yield rests on two important assumptions:

a) You hold the bond until it either matures or is called.

b) The issuer does not default so that you receive all interest payments and your principal.

Note that interest and principal payments are subject to the issuer’s creditworthiness and a higher quoted yield frequently implies a higher risk of the bond defaulting and thus not delivering on its promised cash flow and yield.

As an investor, it’s important to remember that while investing in individual bonds and holding them until maturity or the call date enables you to effectively manage interest rate or market risk, it does heighten the importance of scrutinizing credit risk of each individual issuer while carefully assessing your own liquidity needs.

You can sell individual bonds before the maturity date, although certain bond types that trade in more liquid markets—such as Treasuries and certain corporate bonds—may be easier to sell than most municipal bonds, where markets are thinner and less liquid. Selling before maturity can result in either a profit or a loss, depending on the price you paid for the bonds, the amount of interest you’ve already collected, the current interest rate environment, and the current price of the bonds.

Investing in individual bonds will require sufficient funds to enable you to diversify across several different issuers to ensure a reasonable amount of diversification. Generally speaking, investing in a diversified portfolio of bonds requires at least $100,000–$200,000, depending on the type of bonds chosen and their credit risks. You don’t want to put all your money into a single bond, since there is a risk of default even on high quality bonds. If you’re only buying Treasury bonds or CDs, which have historically been the safest fixed income investment available, you can invest far less without having to diversify quite as much.

Buying individual bonds also means you’re responsible for researching and monitoring the financial stability of the issuer, determining if the bond price is reasonable and building a portfolio around your need for income, risk tolerance and general diversification. Fidelity can help you do this, through our Fixed Income Research Center and Monitoring Alerts.

Bond funds

For many investors, though, a bond fund may be a better approach.

Bond mutual funds are just like stock mutual funds in that you put your money into a pool with other investors, and a professional invests that pool of money according to what he or she thinks the best opportunities are, in accordance with the fund’s stated investment goals. Some bond funds seek to mimic the broad market, investing in short- and long-term bonds from a variety of issuers, such as the U.S. government, government agencies, corporations, and other more specialized securities. Other bond funds focus on a narrower mix of bonds, such as a short-term Treasury fund or a corporate high yield fund.

Whether the fund’s mandate is broad or narrow, bond funds invest in many different securities, so it’s an easier way to achieve diversification even with a small investment. Income payments are made monthly, and reflect the mix of all the different bonds in the fund and the payment schedule of each. As such, the distribution may vary from month to month.

When you sell shares in a fund, you receive the fund’s current net asset value (NAV), which is the value of all the fund’s holdings divided by the number of fund shares, less any redemption fee, if applicable. It’s important to remember that bond funds buy and sell securities frequently, and rarely hold bonds to maturity. That means you can lose some or all of your initial investment in a bond fund.

A Quick Comparison

Individual Bonds

Bond Funds

Management

Investor managed.

Professionally managed.

Maturity Date

Set maturity date (though some bonds may be called prior to maturity).

Generally, no maturity date as bonds are constantly bought and sold.

Fund’s prospectus outlines the weighted average maturity of the bonds in the portfolio.

Income Payments

Usually a fixed semi-annual income payment, some bond income is monthly or quarterly.

Fluctuating monthly income distributions.

Market Risk

If sold prior to maturity, market price may be higher or lower than what you paid for the bond, leading to a capital gain or loss.

If bought and held to maturity investor is not affected by market risk.

Market conditions constantly affect the fund’s value, although the diversification inherent in a fund generally reduces the market risk of any one bond issuer. When you redeem shares of a fund, the sale may result in a capital gain or loss.

Liquidity

You can generally sell a bond prior to maturity on the secondary market. Some bonds are more liquid (trade more frequently) than others: U.S. Treasuries are generally the most liquid, while small municipal issues are generally much less so. A lack of liquidity can result in price volatility, especially in a period of market or issuer-specific stress. In some cases liquidity can disappear altogether for indefinite periods.

Investors can generally sell fund shares at any time, at the current market value (or NAV) of the fund. Some funds may carry a redemption fee.

Diversification

Investor must purchase many bonds from multiple issuers and maturities to achieve diversification—which means it may require a significant investment to achieve diversification.

Bond funds invest in many individual securities, providing diversification for a relatively small investment minimum.

Credit Risk

Higher-rated bonds historically have a lower risk of default.

Dependent on the quality of the underlying securities in which the fund invests (varies by fund type and objective).

Provides diversification, which can mitigate credit risk.

Cost

A markup or markdown upon purchase or sale. The markup/markdown is the difference between the dealer's purchase price and its subsequent sales price to a customer.

Funds carry an annual expense ratio, which usually includes management and other fees.

Important legal information about the e-mail you will be sending. By using this service, you agree to input your real e-mail address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an e-mail. All information you provide will be used by Fidelity solely for the purpose of sending the e-mail on your behalf.The subject line of the e-mail you send will be "Fidelity.com: "

Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.

The Fund Evaluator is provided to help self-directed investors evaluate mutual funds based on their own needs and circumstances. The criteria entered is at the sole discretion of the user and any information obtained should not be considered an offer to buy or sell, a solicitation of an offer to buy, or a recommendation for any securities. You acknowledge that your requests for information are unsolicited and shall neither constitute, nor be considered as investment advice by Fidelity Brokerage Services, LLC., Fidelity Distributors Corporation, or their affiliates (collectively, "Fidelity").